Dongfeng gets into gear

First of China''s big three auto manufacturers pre-markets Hong Kong IPO.

Dongfeng Motor Corp, China's third largest automobile group by market share, embarked on pre-marketing for its Hong Kong Stock Exchange listing last Monday (October 24). Backed by lead managers, CICC, Deutsche Bank and Merrill Lynch, the Wuhan-based group has gone out with a wide proceeds range of roughly $450 million to $650 million.

Such need for flexibility and caution is hardly surprising given how uncertain investor sentiment remains. Dongfeng faces two principal roadblocks.

Firstly market conditions are not good, with primary markets stalling in the face of declining secondary markets, where profit taking has increased in tandem with global policy makers' use of the word inflation. Secondly, the Chinese auto sector has had a terrible year, with the share price of practically every single comparable suffering sharp declines since the announcement of first half results.

Where market conditions are concerned, the leads will obviously be hoping sentiment revives by the time the deal comes to price during the week beginning November 21. It will have a standard Hong Kong IPO structure, with a 10% minimum allocation to retail and a 90.1% and 9.1% split between new and old shares. There will also be a POWL (Public Offering Without Listing) in Japan run by Daiwa SMBC.

In terms of sector specific problems, the deal is being pitched as an attractive investment opportunity into one of China's major manufacturers at a time when the cycle may be turning. A number of analysts believe the price wars and overcapacity issues, which have plagued the industry over the past couple of years, may have almost played themselves out.

If this is the case, the obvious question is why Dongfeng is choosing to raise funds at possibly the cheapest point of the cycle. Indeed, the company originally filed its IPO at the end of 2004, but pulled back after it became clear the sector was in the process of being re-rated down.

Specialists say it is coming back now because management wants to re-pay debt incurred as a result of a shareholder restructuring. Says one, "Dongfeng was originally 56% directly owned by the government and 44% by a group of government pension funds. As a result of the buy-out, it is now 100% government-owned and should return to a net cash position post IPO."

Post greenshoe, the company will offer 30% of its issued share capital and is being pitched on a P/E valuation of about five-and-a-half to eight times 2006 earnings. This valuation is based on a net profit assumption of about Rmb2.2 billion ($272 million) in 2006.

In 2004, Dongfeng reported net profits of Rmb1.2 billion ($148.6 million) and fund managers say syndicate banks are forecasting this to rise to Rmb1.8 billion ($222.9 million) in 2005.

There are already a number of Chinese auto manufacturers listed in Hong Kong, although they are much smaller than Dongfeng and are trading all over the place. At one end of the scale are Brilliance China (mini vans and passenger cars) and Qingling Auto (light trucks), which are both trading on 2006 valuations in the high 20's according to some houses.

At the other end of the scale are Denway Motor (passenger cars) and Chongqing Changan (compact mini vans), which are trading respectively around the level of seven-and-a-half times and four-and-a-half times 2006 earnings.

Chongqing Changan is similar to Dongfeng in terms of scale. Over the first eight months of the year, Changan sold 409,470 units compared to Dongfeng's 473,809 units. The former has a 10% overall market share of the auto sector and the latter a 12% market share.

This puts Changan fourth behind Dongfeng and Dongfeng third behind Shanghai Automotive Industry Corp (SAIC), which has a 15% market share and First Automobile Group, with a 17% market share.

However, fund managers say Denway is being pitched as the closest comparable to Dongfeng even though total unit sales were a much lower 148,412 units. This is because Dongfeng and Denway share a joint venture partner - Honda. Both sell Honda cars, but only Dongfeng manufactures the engines as well.

Historically Denway has traded as high as 30 times forward earnings and has averaged a mid teens valuation. Year-to-date, the stock is down about 18%, but has fallen heavily since its high of HK$3.225 in early August.

Since then it has dropped about 35%, although the really steep slide only began in October, with the stock down 20% on the month. Analysts attribute this recent dismal trading performance to short selling pressure ahead of Dongfeng's IPO.

Likewise, Chongqing Changan has fallen nearly 50% since hitting a year-to-date high of HK$4.78 in mid-August.

As a result of the downturn, Chongqing, Denway and now Dongfeng are being valued at a relatively wide discount to other Asian and world auto comps. Indian auto companies such as Maruti and Tata Motors, for example, are trading in the low teens. So too are Japanese car manufacturers such as Nissan and Toyota, which have big operations on the Mainland.

China's problems stem from a sudden influx of competition and ramp-up in capacity that resulted in fierce price wars and slashed margins during the second half of 2004. According to the State Development and Reform Commission, total profit in China's automobile industry dropped 48.8% year-on-year during the first half of 2005 compared to a 12.6% growth level in the first half of 2004.

Investors now need to decide whether the bad news has played itself out. In an influential 72-page research report published last month, Credit Suisse First Boston argued that it has. The research team commented that, "we do not expect last year's fully fledged price war to be repeated in 2H05, given that passenger vehicle makers' net margin plunged to only 5% in 1H05."

They added that, "channel supply is more controlled this year after the launch of new government policies and China car prices have largely closed the gap with international markets. Even though car sales momentum slowed in July and August, due to seasonality and fuel shortages, eight month year-on-year growth is 22%, well above the consensus range (10% to 15%). Steel price cuts in the fourth quarter should ease automakers' cost pressures next year."

The team concluded that, "selective buying opportunities" are emerging. But is Dongfeng one of them?

Analysts say margin pressures are easing. Dongfeng's operating margin dropped from 14% in 2000 to 5% by the end of 2004. Syndicate analysts are now forecasting it will bounce back to 5.9% by the end of 2005 and 7% by the end of 2006.

Specialists say the industry is being driven by sales growth rather than any likelihood of price increases. As one specialist puts it, "Any drop in the top line would have a huge impact on net margins because they're already so thin. Therefore sales momentum is all about unit growth and making sure prices don't drop any further."

In this respect, Dongfeng scores highly. In the eight months to end August, unit sales were up 47%, the highest growth rate among the top six domestic manufacturers. Second was Guangzhou Auto up 26%, followed by Changan Auto, up 23%.

At the same time, analysts say oversupply is becoming less of an issue because inventory levels are declining and manufacturers are moving from target led production quotas to demand led quotas. Dongfeng is currently running at 82% of total capacity.

They also believe that price wars have eased, even though Shanghai Volkswagan scared the market in early August when it unexpectedly cut prices by 6% to 14%. However, with no signs that other car manufacturers are about to follow suit, analysts have subsequently viewed it as a one-off.

In its research report, CSFB highlighted that Chinese auto prices have dropped 40% since 2000 and have largely come back in line with international markets. Penetration rates, however, remain low - 2% in China compared to 78% in the US, 58% in Japan and 56% in the UK.

The Chinese market is broadly similar in structure to the US, where low fuel costs and taxes have encouraged consumers to opt for large gas guzzlers. There is, for example, currently no fuel tax at all in China and although the government has drawn up plans to introduce one, it has so far opted out because of concerns about high fuel prices. In the US, gasoline is taxed at 30%, while the UK stands at the other end of the scale at 280%.

Similarly, fuel prices are much lower in China than elsewhere. In its research report CSFB cites statistics, which show that one litre cost $0.32 in China in 2003, versus $0.43 in the US and $1.22 in the UK.

It has often been pointed out that China's growing environmental problems are being compounded by its love of large cars. Some commentators believe certain city governments have banned the sale of small cars largely because they do not present the right image for an emergent superpower intent on displaying its wealth to the rest of the world.

Environmentalists argue that the country will need to change its attitude and introduce smaller, more fuel-efficient vehicles. If it does, there will be new manufacturing opportunities, but ones with even lower margins than exist to date.
Commentators also believe the car industry needs to be rationalised, although this will be harder than in other sectors for two main reasons. Firstly, the top six auto manufacturers already control nearly 80% of the entire market.

Secondly, M&A is hampered by the JV structure. Many of the auto companies have multiple foreign JV's, which makes merger agreement difficult. These complicated shareholding structures are also off-putting for investors, who prefer clean corporate structures.

Dongfeng has a 25/25/50 JV with Yueda and Kia (not included in the IPO), a 50/50 JV with Peugeot-Citroen, a 50/50 JV with Honda and a 50/50 JV with Nissan. It has similar hopes of establishing a JV with Renault.

On the plus side, these JV's have transformed Dongfeng from an almost bankrupt manufacturer of military vehicles in the late 1990's. They have provided it with scale, technical expertise and the kind of diversity and stability of earnings that sits well with international investors.

Lead managers are also likely to argue that Dongfeng has a much more balanced profile than many of its listed competitors. This is because it operates in both the commercial and passenger segment of the market, whereas most of its listed competitors are strong in either one or the other.

In 2004, commercial vehicles accounted for 44% of total sales, while passenger vehicles accounted for 28%, engines for 23% (to Denway), and other 4%. In 2005, this is expected to change quite radically with passenger vehicles jumping to 49%, commercial vehicles dropping to 32%, engines to 14% and other 5%.

A lot of growth has come from the Nissan JV, which was signed in 2003. In the eight months to end August, unit sales at the JV grew 162% year-on-year largely thanks to the popularity of the Teana model launched in late 2004.

However, specialists say that losses at the Peugeot-Citroen JV in 2004 will conversely help get the IPO off the ground because they have bought down the company's NAV. As one observer says, "This factor and the payment of a special dividend to the parent means Dongfeng Auto should be able to meet the government's requirement to list above NAV.

"But," he adds, "we also believe it means it will have the market to itself for the next year or so. Shanghai Auto and First Auto both want to secure overseas listings, but they don't look they are going to be able to price above NAV and therefore will have to wait until valuations improve considerably."

A second observer concludes that investors are likely to take a very binary view of Dongfeng's listing. "If they believe the cycle is turning, they'll come into this company because it will be the benchmark listed stock for the auto sector," he says. "If they don't believe it's turned, they'll steer well clear."

So far, the leads appear to have done a good job at securing two early investors to bolster confidence and kick start some momentum. Standard Chartered Private Equity and Temasek have each agreed to buy $50 million of the IPO.

The stock will also pay a dividend, although the amount has not yet been settled.

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